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UK economic outlook update

UK economic outlook update

Also on KPMG.com

The first quarter figures for the UK economy were disappointing, but do they mark the start of a weaker economic environment or do they represent a simple blip?

The beginning of 2017 coincided with a significant turn in fortunes for retail sales. Q1 saw a sharp fall in retail sales volumes, as higher inflation put pressure on households’ purchasing power, although today’s retail sales figures show the good weather encouraged households’ return to the high-street in April. Given that consumer spending equals two third of UK GDP, consumers’ behaviour can swing it for the UK economy.

Consumer confidence, as measured by GfK, continued its decline in April but remains reasonably solid. Unemployment continues to fall and to support confidence, although employment growth has not been spectacular. This is potentially a result of the uncertainty associated with Brexit and the increase in cost pressures resulting from the rise in import costs and the introduction of a number of new employee-related government initiatives.

After a brief pick up last year, there are signs that the growth in average earnings is losing momentum, with the rise in inflation causing real wages to drop. The housing market has also experienced a change in fortunes, with an increasing number of UK regions experiencing some decline in house prices since the start of the year. We therefore expect households to tread more cautiously and for consumer spending growth to moderate over the coming two years (see table below).

Investment growth decelerated markedly last year, with the rise in uncertainty associated with the UK decision to leave the EU potentially making an impact. We expect business investment to remain weak this year, before beginning to recover in 2018, as companies gain more clarity on the exit process and outcome. The pound has picked up a little, although it remains well below its peak prior to the EU referendum, with survey evidence pointing at a pick-up in exports, thanks to the weaker pound and to supportive global economic environment. Overall, we therefore expect UK economic growth to fall marginally this year, before slowing slightly further next year (see table below).

There is evidence that businesses have so far passed only part of the rise in import costs on to customers, and as currency hedges gradually expire for those who were hedged, businesses may seek to recover more of their costs. We therefore think inflation could peak at just under 3% by the start of next year before beginning to moderate, with average inflation for the next two years remaining above the Bank of England target of 2%.

The tight labour conditions, together with the elevated inflation, could see the Bank of England raise interest rates as early as next year. The government’s decision to hold an early election next month means the following general election may not need to take place until as far as 2022, paving the way for a potentially smoother transition from the EU and removing some of the ground for the Bank of England to hold fire for the next two years. The start of a tightening cycle could prove a significant milestone, as after over a decade of no rate rise it could trigger a re-assessment of debt affordability among borrowers.

Despite the relative calmness so far this month for the exchange rate, businesses may wish to plan for further volatility. Events beyond the UK border, such as changes to US economic policy and the forthcoming European elections could potentially make an impact, and the time of relative lull could prove a good opportunity to find a more reasonably priced hedge.

We could see volatility extend beyond markets, and businesses should use alternative scenarios in their planning. With so much dependent on sentiment during the negotiation period, the probability of a divergent scenario occurring is high.